Development Of Commodities Investing
Commodities markets are some of the oldest markets in the world. They have existed for thousands of years, and today’s commodities exchanges have been around for hundreds of years (the Chicago Board of Trade (CBOT) was founded in 1848 and traded its first corn contract in 1951). Despite being old markets, access to commodities for ordinary investors is still a new phenomenon. Although commodities futures have existed for many decades—agriculture futures are some of the oldest, whereas the NYMEX’s WTI oil futures started trading in 1983—commodities futures markets have been the domain of sophisticated investors. As a result, investors have previously been excluded from exposures that may benefit a portfolio’s performance.
During the last decade, commodities markets went through some fundamental changes, including (1) increased investor appetite for alternative asset classes, (2) record-low inventories coupled with tight supply, and (3) increasing demand for raw materials from emerging markets such as China and India. These factors have led to the development of a wide range of structured products on commodities. Continued demand by investors for access to simple and direct commodities exposure has more recently led to the development of exchange-traded commodities (ETCs), with Europe being the world leader in ETCs. Over the past five years, more than 140 ETCs have been listed in London, with 14 of these ETCs providing exposure to oil.
Commodities Are Priced Off Commodities Futures
One significant difference with commodities investment is that nearly all “direct” commodities investment is priced off commodities futures. This means that while commodities investing will track commodities prices, there can be slight nuances resulting in varying returns. The most common question is “Why not just price off physical spot prices?” The reason is that most physical commodities are difficult to price off because they are heterogeneous (differing in quality, weight, type, value, origin); are often hard to store and may disintegrate; and are difficult to transport, and thus illiquid. As a result, all barrels of oil or bags of coffee are not fungible (i.e., they are not all the same). Futures pricing solves all these problems. Futures contracts are standardized contracts, meaning that they are fungible. As a result, futures prices are liquid and get around the problems inherent in physical commodities. However, since commodities futures are not exactly the same as physical barrels of oil, this leads to differences in investment returns. Figure 1 shows that over the past 10 years, ETFS Brent 1 month would have outperformed the Brent “spot” oil price; however, both went through periods of relative over- and underperformance.
Pricing Using Oil Futures
Figure 1 shows that an investment in oil futures can perform differently than the spot oil price (which is uninvestable). Oil futures returns are driven by three sources: (1) oil prices, (2) roll yield, and (3) interest on collateral. The roll yield is a result of the fact that oil futures expire. To prevent expiry of the oil futures (and delivery of 1,000 barrels), it is necessary to “roll” the investment. This involves selling the current oil futures contract and reinvesting the funds in a later-dated contract, thereby avoiding expiry and keeping the investor fully invested. This process of rolling can lead to either a positive effect (backwardation) or a negative effect (contango). Thus an investment in oil futures (or oil ETCs) may outperform or underperform the spot oil price at different times.